The Risks of Investing (in SweetSpot and Otherwise)

The major risk we face as SweetSpot investors is “market risk.” If the broad stock market is declining, we can hope to lose less or maybe even profit a little, but we are unlikely to do well in absolute terms. We won’t be all that happy about beating the market by 10 points if the market is down 20 points. That means we lost money, never a good thing. Still, over time it has paid to train ourselves to ignore the market’s short-term ups and downs as so much noise.

We can expect SweetSpot to do well in the long run, both in absolute terms and relative to the market (but no guarantees!).* The short run, however, is anybody’s guess, and the short run can be longer than we think. Therefore, we should only invest money that won’t be needed for five years or longer.

In weighing investment risk, most investors want to know: “Will I lose money?” They may be leery of SweetSpot’s historical track record of outperformance, having heard the conventional wisdom that no investment strategy can outperform the market over time. If confronted with a track record that has done just that, conventional wisdom has a ready answer: It is only possible to outperform the market by taking on a level of risk that exceeds market risk.

In 2014, SSI performed research that addressed this issue and others. The study looked at 77 completed multi-year trades that either were, or would have been, entered between 1989 and 2011 using SSI’s established method.** Each trade was held for an initial three-year period, and longer if: 1) it was renewed (that is, identified as a new buy in subsequent years); or 2) it underperformed the market in its first three years. Between renewals and underperformers, 41 of 77 completed trades were held for longer than three years.

The study defined “risk” as the probability that one would have suffered a loss when a trade was closed out. The results:

Seventy-two of 77 completed trades were profitable, whereas the market was profitable in 52 of 77 corresponding periods. The profit-to-loss ratio for SweetSpot was 93.5 percent, versus 67.5 percent for the market.

We saw a 6.5-percent incidence of losing SweetSpot trades, whereas the corresponding rate of market losses was 32.5 percent. Bottom line: The market was five times more likely than SweetSpot to generate a losing trade.

SweetSpot’s relative profitability was consistent throughout the test period, with every trade year but one generating a greater number of profitable trades than the market. (The market prevailed, 23 to 22, in year five.)

It helps to know that risk is far greater when an asset is richly priced, something that SweetSpot investments rarely are at the time a trade is entered. Still, anything can happen. Backtesting showed that we should expect to suffer an occasional losing trade. And markets can move in ways that are not predicted by either our real-time experience or historical backtesting. Every now and then, maybe we’ll see a chart that looks something like this:

Cheer up — this bleak scenario presents an opportunity: Consider that SweetSpot’s reported performance is based on the date a trade is first entered. Only when the price goes down from there can we improve upon that performance (by adding shares at the lower “actual sweet spot” price). Maybe we should be rooting for a weak start every time, as long as we’re confident that we’ll recover by the time we sell. Of course there are no guarantees, but given SweetSpot’s favorable historical risk/reward profile, broad diversification across market sectors, and hands-off nature, it’s hard not to like our chances.

*Past performance is not an assurance of similar future returns.

**Disclaimer: Backtests do not represent actual trading; they may not reflect the impact that material economic and market factors might have had on your adviser’s decisions if your adviser were actually managing the tested strategy during the backtest period. No representation is made that investors will see profits similar to hypothetical past results.

Sketches from behaviorgap.com are reproduced here with the permission of the artist, Carl Richards.

The SweetSpot Portfolio’s past results are not a guarantee of similar future performance.